Taxes affect your hard-earned money, but you cannot avoid them. However, you can plan for taxes so that you eventually do not end up paying more to the government than necessary. By understanding how different tax rules and strategies can help reduce your tax bill, you have a greater chance of saving more money for retirement. Retirement plans comprise pre-tax or after-tax contributions or a combination of both. Each type of contribution has a significant impact on your retirement income. Hence, it is beneficial to consult a financial advisor to understand which contribution suits your financial situation the best. Retirement accounts, in particular, with after-tax contributions have become increasingly popular because of their tax-saving benefits.
Here is what you should know about after-tax contributions:
To encourage people to save for their retirement, the government offers several tax-advantaged retirement plans. The most popular ones are a 401(k) and an IRA (Individual Retirement Account). A 401(k) is an employer-sponsored plan, whereas an IRA is offered by an authorized financial institution like a bank. Both retirement plans comprise different kinds of contributions.
The traditional 401(k) and IRA allow you to deposit only pre-tax money. However, the Roth versions of both these retirement accounts permit you to make after-tax contributions. After-tax contributions are also known as non-concessional contributions and are typically defined as deductions made from your salary after your income tax is cut for a specific year. Essentially, retirement plans with after-tax contributions comprise dollars that have already been taxed. Hence, these contributions do not reduce your income, and you cannot deduct them on your annual tax return. This is in contrast to pre-tax contributions that are deducted from your salary before your income tax is charged. Thus, reducing your taxable income.
In the case of Roth accounts, since you have made after-tax contributions, you owe no further taxes on the account balance even at the time of withdrawal. That said, in the case of traditional retirement plans with pre-tax dollars, the IRS (Internal Revenue Service) gets its due when you withdraw your funds.
Both pre-and post-tax retirement accounts have a specific contribution limit.
You can have more than one pre-and post-tax retirement accounts. However, the overall contribution limit for all accounts will remain the same, as specified above.
Besides some employers also allow you to make after-tax transfers in a traditional 401(k) plan. So, if you hit the annual pre-tax 401(k) contribution limit, you can deposit an additional after-tax sum up to $38,500 in your traditional 401(k) account. Earnings on after-tax contributions are treated as pre-tax by the IRS and can grow tax-deferred until withdrawn. You can also roll over your after-tax 401(k) portion into your Roth IRA for greater benefits. Besides, in some cases, following a special provision of the tax code, you can take out the after-tax part of your traditional 401(k) plan as soon as you retire.
That said, the IRS changes the contribution limits and other rules for these accounts every year. Hence, it is advisable to consult a financial advisor regarding your after-tax contributions so that you make the most of these retirement plans.
Before deciding on the type of contribution to opt for, it is advisable to engage with a financial advisor to better understand the pros and cons of after-tax contributions, and to know if these contributions suit your financial needs and retirement goals.Pros of after-tax contributions
The main advantage of after-tax contributions is that your retirement funds are not subject to any further taxes. This provides your money a better opportunity for tax-deferred growth in the long-run. Thus, post-tax deposits make the most sense for you if you expect yourself to fall in a higher tax bracket during the retirement years of your life. This could be because of an increase in your future retirement income or a hike in the future tax rates.
Another benefit of post-tax contribution is that you can withdraw your funds at any time without the IRS levying any penalties if you meet certain criteria. The conditions when your withdrawals are tax-free include:
However, in the case of pre-tax or traditional accounts, if you take the distributions before the authorized age of 59.5, the IRS will charge a penalty of 10%, in addition to the income tax liability on withdrawals. Besides, after-tax contributions also help you mitigate your retirement tax burden in another way. If you make these contributions, then at the time when you leave your company or take official retirement, you will have an option to roll over the tax-deferred growth into a traditional IRA, and rollover your after-tax 401(k) contributions into a Roth IRA.Cons of after-tax contributions
One of the major drawbacks of after-tax contributions is that your paycheck gets smaller with every contribution you make to your Roth 401(k) or IRA. Alternatively, pre-tax contributions reduce your taxable income for the year, and ultimately your tax liability for the year in which you make the contribution.
After-tax contributions are suitable in the following conditions:
There are multiple retirement plans, each with different rules regarding contributions, withdrawals, and taxation. Moreover, the tax landscape changes frequently, which makes retirement planning a bit complex without the sound advice of a professional financial advisor. So, when it comes to retirement planning, consider consulting a professional financial advisor to understand which type of contributions or retirement plans suit your financial goals and situation.
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